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Shanda Interactive Entertainment (SNDA) SINA Corporation (SINA) Shanda acquires 19.5% of Sina; we view a swap ratio of 0.9:1.0 as fair The Goldman Sachs Group, Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Customers of The Goldman Sachs Group, Inc. in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at independentresearch.gs or can call 1-866-727-7000 to request a copy of this research. For Reg AC certification, see the text preceding Appendix 1. 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Note February 20, 2005 Shanda Interactive Entertainment In-Line/Neutral Stock data Price US$30.01 Price target US$33.00 52-week range US$45.40 - 10.58 Dividend yield 1.1% Capitalization Market cap US$2,092 mn Enterprise value US$1,715 mn Net debt/equity NM Shares outstanding 69.7 mn SINA Corporation In-Line/Neutral Stock data Price US$25.60 Price target US$26.00 52-week range US$46.21 - 18.88 Dividend yield - Capitalization Market cap US$1,287 mn Enterprise value US$1,111 mn Net debt/equity NM Shares outstanding 50.3 mn James Mitchell, CFA james.mitchellgs Hong Kong: +852-2978-1450 Ada Ho ada.hogs Hong Kong: +852-2978-1261 Goldman Sachs Global Investment Research Summary: Shanda announced in a SEC filing after the market close on Feb 18 that it has acquired 19.5% of Sinas shares using cash on hand, the vast majority immediately following Sinas 4Q2004 results release on Feb 8. The transaction itself is earnings accretive - we raise our Shanda 2005 fully diluted (FD) EPS estimate by 8% to US$1.42 and 2006 by 7% to US$1.60 to reflect Shanda equity accounting its stake and thus booking 19.5% of Sinas earnings ($13 mn boost), offsetting foregone interest income ($4 mn reduction). A full acquisition would be earnings dilutive given Shanda is at 23X our 2005 FD EPS while Sina is at 25X; we view Sinas earnings quality (60% wireless) as lower, though Shanda might boost Sinas earnings through leveraging its prepaid card network. We assume Shanda will wait and watch Sinas share price next week, and consider a share swap acquisition at a ratio of not more than 1:1.We have an IL rating on Shanda and a 12 month target price of $33 based on 21X our 2006 forecast EPS; risks include loss of massive multiplayer game players to rival game World of Warcraft. We have an IL rating on Sina and a 12 month target price of $26 based on 20X our 2006 fully diluted EPS; risks include over-reliance on wireless and specifically SMS/MMS products. Forecasts and valuation - Shanda Interactive Entertainment Net Income EPS EPS Growth P/E EV/EBITDA Div. Yield Fiscal year ended US$ mn US$ % X X 12/02A 16.8 0.33 4,533.3 89.6 84.4 - 12/03A 27.9 0.60 78.4 50.2 58.3 - 12/04E 71.2 1.02 71.2 29.3 25.1 1.1 12/05E New 118.3 1.70 66.1 17.7 15.8 - 12/05E Old 109.5 1.57 - - - - 12/06E New 133.8 1.92 13.0 15.6 13.9 2.4 12/06E Old 124.7 1.79 - - - - Forecasts and valuation - SINA Corporation Net Income EPS EPS Growth P/E EV/EBITDA Div. Yield Fiscal year ended US$ mn US$ % X 12/02A (4.9) (0.11) 83.8 NM (2,520.1) - 12/03A 31.4 0.66 NM 39.0 25.3 - 12/04E 66.0 1.33 102.5 19.2 14.2 - 12/05E 65.6 1.29 (3.3) 19.9 14.6 - 12/06E 76.3 1.50 16.3 17.1 12.5 - Source: Company data, Goldman Sachs Research estimates Shanda Interactive Entertainment / SINA Corporation February 20, 2005 Goldman Sachs Global Investment Research 2 Shanda has in the past traded out of some investments (e.g. the Rmb41 mn investment income it booked in 4Q2004, which may have been from a prior foray into Sina shares) and moved to full control of others (e.g. buying 29% then a further 9% in Actoz in 4Q2004). We believe Sinas stock price may initially trade up strongly, then fall back if Shanda does nothing and no alternate acquirers emerge. Shandas stock price may take an initial hit on fears of it issuing stock to pay for a bigger stake in Sina and on investor concern that Shanda will now face wireless service risk, then rebound if Shanda does nothing. If Shandas share price does not rise, we would thus be sellers of Sina above $31 (same price as Shandas current price and 25X Sinas 2006 FD EPS). Netease, Tencent, and Sohu may trade up on hope that they too could be acquisition targets, but: (1) we do not view them as targets given they each - unlike Sina - have a controlling shareholder unlikely to sell at anywhere close to current prices; (2) a merged Shanda-Sina entity could prove a formidable competitor, especially to Sinas traditional rival Sohu. RECENT EVENTS SUMMARY Shanda disclosed in its 4Q2004 results that it had made an investment profit of Rmb41 mn trading shares in another listed company, which may have been Sina - Sinas share price varied between $21 and $40 during that quarter. Shanda has now disclosed that its unlisted parent entities bought 0.7 mn Sina shares for $19 mn (or $25-$30 per share) in January, and that Shanda itself bought 9.1 mn Sina shares for $211 mn (or around $23 per share) on February 8-9. Shanda expects to purchase the shares belonging to its parent entities at cost. The 13D filing states that The Securities have been acquired for strategic investment purposes. Depending upon various factors. Shanda may consider increasing its stake. seeking to acquire or influence control of the Issuer. seeking a merger, consolidation, or other business combination. Shanda may engage in discussions with the Issuer to explore the possibility of a business combination transaction. Although Shandas parent entities paid as much as $30 per Sina share in January, we do not think that Shanda would necessarily pay much more than $30 in the future, given: 1. We believe Shanda is more likely to use shares than cash for acquisitions henceforward (see below). 2. Shandas share price has recently declined. 3. Sinas 4Q2004 results caused analysts to cut their 2005 earnings estimates by 20%-40%. COMBINED ENTITY (“MERGECO“) WOULD DOMINATE CHINA INTERNET LANDSCAPE. Combining our stand-alone models, we estimate a merged Shanda-Sina entity (what we call “mergeco“) would generate about $470 mn of revenues in 2005 (53% Shanda, 47% Sina), $185 mn of EBITDA (59% Shanda, 41% Sina), and $176 mn of net income (62% Shanda, 38% Sina). Mergeco would thus not only dwarf any one of the other Chinese Internet stocks - e.g. Tencent (2005E $160 mn revenue, $65 mn EBITDA, $58 mn net income), Netease (2005E $156 mn revenue, $74 mn EBITDA, $67 mn net income), Sohu (2005E $111 mn revenue, $40 mn EBITDA, $35 mn net income) - but also any two of them put together. The aggregated market capitalization of Shanda and Sina together is currently $4.2 bn. .BUT FACE SOME EARNINGS HEAD-WINDS Neither company discloses EBIT by product line. Looking at the revenue mix, we estimate massive multiplayer games would contribute 37% of the group total; wireless services 26%; online advertising 19%; casual games 11%; other diversified 8%. We believe most observers would agree that mergecos wireless services would face a difficult 2005 given mergecos 4Q2004 wireless service revenue would have relied 80% on SMS (hit in the short term by bans on TV advertising, and in the medium term by consumers shifting to newer products) and 12% on MMS (hit in the short term by policy changes). We estimate mergecos advertising business could grow at a decent (c.30%) rather than a spectacular pace in 2005 given industry fragmentation and the Sina management teams readiness to invest in content in order to open up a traffic lead over Sohu. We would like mergecos massive multiplayer online game business structurally but fear that both Shandas 2D games (Mir 2, World of Legends) and Sinas 3D game (Lineage 2) could show slowing growth from 2Q2005 due to people instead playing rival game World of Warcraft. Earnings growth in 2005-2006 would thus rely to some extent on business lines that are not currently major revenue drivers. MERGECO WOULD ENJOY SUBSTANTIAL FINANCIAL, CROSS-MARKETING, MANAGERIAL FIREPOWER What we see as perhaps the most appealing feature of mergeco is that it could use Shandas prepaid card distribution system to better monetize Sinas various Internet applications (portal, e-commerce, Instant Messaging, etc.). Shanda has already demonstrated this ability to leverage its payment network - which matters in China due to lack of credit cards - through its casual games. We believe this process would take 12-24 months to ramp up. SYNERGY BENEFITS FROM REVENUES RATHER THAN COSTS There are few business overlaps between Shanda and Sina. We assume mergeco would consolidate: 1. Its stake in the NCsina game company into its massive multiplayer game division. 2. Advertising sales on the poptang game portal with advertising sales on the Sina general portal. Shanda Interactive Entertainment / SINA Corporation February 20, 2005 Goldman Sachs Global Investment Research 3Mergeco would likely maintain a two city (Shanghai and Beijing) headquarters strategy, since the Beijing office is useful for interacting with China Mobile and China Unicom. DIFFICULT TO ARGUE MERGECO WOULD TRANSFORM SINAS WIRELESS BUSINESS We believe Sinas wireless difficulties stemmed from industry-wide challenges more than Sina-specific mistakes. Shanda offers some wireless games but these are generally single player only due to bandwidth and screen constraints. LINEAGE 2 MIGHT SUPPORT SHANDAS GAME BUSINESS Sina has around 65,000 average users for its 3D game Lineage 2, which would help update Shandas largely 2D game portfolio. However NCsoft collects 30% of the revenue and 50% of the earnings from Lineage 2, and World of Warcraft appears to be decisively overshadowing Lineage 2 in other markets ex-Korea. FITS SHANDAS SELF-DESCRIPTION AS ENTERTAINMENT COMPANY Shanda has always taken pains to describe itself as a broad entertainment rather than a narrow computer game business, so we believe acquiring Sina would be in-step with its self image. BID LIKELY UNINVITED, PROBABLY NOT HOSTILE There is no evidence that Sina solicited the transaction. However we assume that Shanda management had informed Sina management of its investment. MANAGEMENT SHOULD MESH We believe the management fit between Shanda and Sina could be straightforward given Shandas CEO, as the largest shareholder in a combined entity, would presumably receive a group-wide leadership position, while the bulk of Sinas management could receive divisional leadership roles in the wireless and portal businesses. COUNTER-BID POSSIBLE, NO OBVIOUS CANDIDATES At this stage we do not see an obvious alternate bidder for Sina. Part of Sinas portal popularity flows from its priority access to local news, and we believe that Chinas news agencies might adopt a less preferential attitude if a foreign company were to acquire Sina. The other listed local Internet stocks are typically of a size where they would likely be targets rather than acquirers of Sina. SHANDA COULD WALK AWAY FROM ANY BIDDING WAR WITH A PROFIT Shanda would not be a weaker company than it is today if someone else acquired Sina, unless that bidder were a game rival such as Netease or The9 - which appears unlikely, in our view. We therefore believe that if a bidding war broke out, Shanda could sell its 19.5% stake and collect a substantial profit. TRANSACTION DOES NOT MEAN THAT SHANDA NEEDS TO BUY GROWTH Acquisitions often represent a means for the acquirer company to “buy“ earnings growth at a time when its own business is slowing down. This may not be a fair characterization of Shandas situation since Sina arguably faces more growth constraints (especially in 2Q2005) than Shanda, and since Shanda could have bought a smaller but “growth-ier“ target to achieve the same result more efficiently. TAKING A CONTROLLING STAKE WOULD REQUIRE SHANDA ISSUES EQUITY / DEBT Shanda ended 2004 with cash and investments of $440 mn. Its debts were limited to a convertible bond issue of $275 mn. The acquisition of 2.6 mn shares in Actoz for $92 mn closed in January. Its cash on hand prior to the Sina investment was thus $348 mn. Shanda itself spent $211 mn on Sina shares and has stated it will soon acquire the shares which its unlisted parent entities hold for $19 mn. We estimate Shanda has around $120 mn cash on hand left, sufficient for a further 7% stake in Sina. SHARE SWAP IN OUR VIEW MORE LIKELY THAN DEBT FINANCED ACQUISITION We estimate for Shanda to acquire the residual 80% of Sina at (for example) $30 per share would require incremental debt financing of around $1.1 bn. Shanda and Sina already have a combined $374 mn of convertible debt outstanding that we believe could be put back to mergeco in 2007. A total debt burden of $1.3 bn (net of convertibles and Sinas existing cash balance) would represent 7X mergeco cash flow and EBITDA. WE ESTIMATE SHANDA DESERVES A 2 POINT (10%) P/E PREMIUM OVER SINA We usually view a mid-teens P/E multiple as fair for wireless services; 22X for online games; and mid-20s for online advertising. Our target 2006 P/Es are thus 22X for Shanda (ex Sina stake) and 20X for Sina. Shandas purchase of 9.13 mn shares at $23.1 appears rational to us, since Sinas P/E was then 18X while Shandas was 22X. ECONOMICS FAVOR SINA SHAREHOLDERS IF SWAP RATIO IS 0.9 SHANDA : 1.0 SINA OR MORE If Shanda believes it can grow Sinas earnings 20% above where they would otherwise have been through use of its prepaid card network and through combined marketing muscle, then we believe Shanda could theoretically be willing to pay a 2 multiple point premium to buy Sina, even though our stand-alone fair values indicate a 2 point discount. We forecast Sinas 2006 FD EPS at $1.31 on a stand-alone basis, Shanda Interactive Entertainment / SINA Corporation February 20, 2005 Goldman Sachs Global Investment Research 4and Shandas at $1.49 prior to the 19.5% associate contribution from Sina. We provisionally assess that a fair share swap ratio could be about between 0.9 (if synergy benefits flow to Shanda investors) and 1.0 (if benefits to Sina investors) Shanda shares per Sina share. AT 0.9 SHANDA : 1.0 SINA, SHANDAS 2006 EPS COULD BE $1.66-$1.83 There are 51 mn Sina shares outstanding (59 mn fully diluted), and Shanda already owns 9.8 mn. If Shanda purchased the remaining Sina shares at a 0.9:1.0 ratio then Shandas FD ADR count (including dilution for Shanda and Sina convertible bonds, and for share options) would incre
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